Copyright: M. S. Humayun1 Financial Management Part II (Securities) Lecture No. 13 Intro to Bonds - Classification & Concepts (Direct Claim Paper Securities) Batch 4-1

Copyright: M. S. Humayun2 Securities Securities : pieces of legal contractual paper that represent claim against assets –Direct Claim Securities: Stocks: equity paper representing ownership, shareholding. Appears on Liabilities side of Balance Sheet Bonds: debt paper representing loan or borrowing. –When you are Issuing Bonds (ie. Borrowing money) then the Value of Bonds appears under Liabilities side (as Long Term Debt) of Balance Sheet. –If you are Investing (or buying) Bonds of other companies then their Value appears under Assets side (as Marketable Securities) of Balance Sheet. Value of Direct Claim Security is directly tied to the value of the underlying Real Asset.

Copyright: M. S. Humayun3 Bond Concept Textile Weaving Factory Case Study A Textile Weaving Factory uses thread to make cotton fabric and then sells cotton fabric to earn cash receipts. It needs Rs 1 million to make a Capital Investment in looms and machinery. It can raise money for a period of 1 year by Debt Financing by Issuing a 1 year Mortgage Bond whereby it pays the Lender (ie. Investor or Bondholder) 15% pa Coupon Interest Rate. The Lender’s (or Bond Holder’s or Investor’s) money is protected because the Mortgage Bond is Backed (or Secured) by Real Property such as the land, factory building, and machinery. Upon Maturity, after 1 year, the Bond Issuer will return the Par or Face Value (or Principal Amount of Rs 1 million) to the Lender.

Copyright: M. S. Humayun4 Bond Concept Why raise money through a Debt (ie. Bond) rather than through Equity (ie. Shares or Stocks)? –If the Company raises money using Bonds, then it will have to pay a fixed amount of interest (or mark-up) regularly for a limited amount of time. But failure to pay interest can force company to close down. –If the Company raises money using Equity, then it is forced to bring in new shareholders who can interfere in the management and will get a share of the net profits (or dividends) for as long as the company is in operation ! The amount of dividends can vary. The Value of the Bond can be calculated from the Cash Flows attached to the Bond. Those Cash Flows depend on the Cash Flows from the Real Business ie. The textile factory’s cash flows from sale of fabric. This is why the Bond is called a Direct Claim Security whose value depends on the value of some underlying real asset.

Copyright: M. S. Humayun5 Bond (TFC) Concept A Limited Company can raise money by Issuing (or selling) Debt in the form of Bonds (similar to TFC’s in Pakistan). In Pakistan, the Par Value (or Face Value) of each TFC is generally Rs The Life of a Bond is generally limited (or finite) ie. 1 year, 3 years, 5 years,... As the financial health (cash flows and income) of the company changes with time, the Market Value (or Price) of the Bond changes (even though its Par Value is fixed). Market Prices also change depending on the Supply-Demand for the Bond (or TFC) and Investors’ Perception. TFC’s of Listed Public Limited Companies are traded in the Stock Exchange like KSE (Karachi Stock Exchange), LSE (Lahore), ISE (Islamabad).

Copyright: M. S. Humayun6 Bonds: Definition Bond is a type of Direct Claim Security (a legal contractual paper) whose value is secured by Real Assets owned by the Issuer. Bond is Issued by the Issuer (or Borrower) to the Bondholder (or Lender or Investor or Financier) in exchange for the cash. Borrowers and lenders can be individual persons or companies or governments. Examples: Term Finance Certificate (TFC issued by Public Listed Industrial Companies), Defense Saving Certificate (DSC issued by Government), T-Bill (issued by Government) Bond is a Legal Contractual Paper Certificate that represents Long Term Debt (or Long-term Promissory Note) –Bond paper contains legal & numerical points

Copyright: M. S. Humayun7 Bonds: Numerical Features Maturity or Tenure or Life: Measured in years. On the Maturity Date when the bond expires, the Issuer returns all the money (Principal/par and Interest/coupon) to the Investor (thereby terminating or Redeeming the bond) ie. 6 months, 1 year, 3 years, 5 years, 10 years, … Par Value or Face Value: Principal Amount (generally printed on the bond paper) returned at maturity ie. Rs 1,000 or Rs. 10,000. Contrast this to Market Value (or Actual Price based on Supply/Demand) and Intrinsic or Fair Value (estimated using Bond Pricing or Present Value Formula) Coupon Interest Rate: percentage of Par Value paid out as interest irrespective of changes in Market Value ie. 5 % pa, 10 % pa, 15% pa, … etc. Coupon Receipt = Coupon Rate x Par Value. Coupon Receipts can be paid out monthly, quarterly, six-monthly, annually…etc. Contrast to Market Interest Rate (macro- economic).

Copyright: M. S. Humayun8 Bonds: Characteristics & Legal Points “Indenture”: Long Legal Agreement between the Issuer (or Borrower) and the Bond Trustee (generally a bank of financial institution that acts as the representative for all Bondholders). –Basically protects Bondholders from mis-management by the bond issuer, default, other security holders, etc. Claims on Assets & Income: Bondholders have the First Claim on Assets in case the company closes down (Before Shareholders). –The Financial Charges due to Bond Holders must be paid out from the Income before any Net Income can be distributed to Stockholders in the form of Dividends (see P/L Statement). –If Issuer (or Borrower) does not pay the interest to the Bondholder (ie. Default), then the firm can be legally declared Insolvent, Bankrupt, and forced to close down.

Copyright: M. S. Humayun9 Bonds: Characteristics & Legal Points Security: Mortgage Bonds are backed by real property (ie. Land, building,, machinery, inventory) whose value is generally higher than that of the value of the bonds issued. Debentures and Subordinated Bonds are not secured by real property but they are backed by personal and corporate guarantees and their security and value is tied to the anticipated future cash in-flows of the business. Call Provision: The right (or option) of the Issuer to call back, redeem, or retire the bond by paying-off the Bondholders before the Maturity Date. When market interest rates drop, Issuers (or Borrowers) often call back the old bonds and issue new ones at lower interest rates.

Copyright: M. S. Humayun10 Bond Ratings & Risk Bonds are rated by various Rating Agencies: –Internationally: Moodys, S&P. –In Pakistan: Pacra, VIS. Based on future Risk Potential of the company that is the Issuer of the bond. Bond risk increases with: –operating losses (check Cash Flow Statement and P/L) –excessive borrowings or debt (check Balance Sheet) –large variations in income –small size of business –country and foreign exchange rate risk International Bond Rating Scale (starting from the best or least risky): AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Also + is better and - is worse. So A+ is better than A. A- is worse than A.

Copyright: M. S. Humayun11 Types of Bonds Mortgage Bonds: backed & secured by real assets Subordinated Debt and General Credit: lower rank and claim than Mortgage Bonds. Debentures: not secured by real property, risky Floating Rate Bond: coupon rate not fixed Eurobonds: issued from a foreign country Zero Bonds & Low Coupon Bonds: no regular interest payments (+ for lender), not callable (+ for investor) Junk Bonds & High Yield Bonds: high-risk debt with rating below BB by S&P Convertible Bonds: carry option to convert to equity